Wolves at the door

Nov 6th 2008 | WASHINGTON, DC
From The Economist print edition

Financial mess and gathering recession dominate Barack Obama's agenda

HE HAD always planned for the economy to be his priority. Just not this economy.

As candidate, Barack Obama crafted a platform to address the concerns that preoccupied voters earlier this year: high energy and health-care costs, stagnant middle-class incomes and rising foreclosures. But such problems pale beside the eruptions since August. America’s housing crisis has become a global financial panic; the economy, which was muddling along as recently as July, may be in its deepest recession in decades. Consumer confidence, as our chart shows, is at its lowest in more than half a century (except for a brief sharp dip in 1980).

Only twice since the 1920s has economic angst played such an important role in a presidential election—and both the previous occasions make imperfect templates. When Franklin Roosevelt defeated Herbert Hoover in 1932, the Depression had been going on for three years, thousands of banks had failed and unemployment was 25%. When Ronald Reagan beat Jimmy Carter in 1980, inflation had been high for years, hovering at 12% as voters headed to the polls. The current crisis has been under way for little more than a year, the first failure of a big financial institution was in March and the latest figure for unemployment (in September) was just over 6%. Inflation this year topped 5%, mostly because of soaring petrol prices, and is now heading down.

What distinguishes today’s economic environment is that it is such a sharp break from a long period of low inflation and shallow recessions, an era lasting 26 years which some economists named “the great moderation”. Indeed, the median-age voter this year has known little else, notes Michael Barone, a political expert at the American Enterprise Institute. There have been financial upsets, such as the 1987 stockmarket crash and the 2001 dotcom bust. But they lacked the destructive power of this year’s financial tempest which has capsized banks, money-market mutual funds, insurers, hedge funds, car manufacturers—and countries as disparate as Iceland and Ukraine.

Against this background, Mr Obama confronts three distinct though related challenges: the financial crisis, mortgages and foreclosures, and recession. Of these, the financial mess has to be dealt with first. “Problems in the financial system”, explains Douglas Elmendorf, an economist at the Brookings Institution, “evolve in a matter of hours, days and weeks.”

If Mr Obama is lucky, he will take office on January 20th with financial affairs more or less under control thanks to steps taken by Henry Paulson, the treasury secretary, and the Federal Reserve. The government is buying equity in banks and guaranteeing their debt, and the Fed has dramatically expanded its lending to all manner of borrowers. There are signs of success. Stocks have risen from their lows of a week ago. Banks are growing a bit more willing to lend to each other, judging by the decline in rates on three-month interbank dollar loans (although that rate remains extremely high in relation to the Fed’s target rate).

But for the healing to continue more government intervention will almost certainly be needed. As a slumping economy turns more debts bad, more financial firms will founder—and Mr Obama must decide whether to rescue them. He will press for conditions, such as lending commitments, which Mr Paulson shied away from.

The Treasury is expected to ask for the second $350 billion tranche of the $700 billion in bail-out funds. It may even need more as the list of supplicants grows. GMAC, the finance affiliate of General Motors, which said on Wednesday November 5th that its mortgage unit might fail, is seeking access to the Treasury’s bail-out funds. Insurers want to qualify too. Sheila Bair, chairman of the Federal Deposit Insurance Corporation, a bank regulator, is pressing for more aggressive (and costly) measures to reduce foreclosures. Some non-financial companies, such as the carmakers, will also come close to bankruptcy. Their requests for help will get a sympathetic ear from Mr Obama.

Because of the extreme fragility of market confidence, the way the presidential transition is handled is crucial. Mr Obama’s preparations have been extensive and George Bush himself has prepared the ground for a smooth handover. The president-elect may name the main members of his economic team within days to reassure investors that the replacement of Mr Paulson will be seamless. Both Lawrence Summers, who held the office under Bill Clinton, and Timothy Geithner, the president of the Federal Reserve Bank of New York, are on the shortlist of candidates to take over. Mr Bush has even been urged to take the unprecedented step of nominating some of his successor’s team. But Stephen Hess, at the Brookings Institution, gives warning that this could force Mr Obama to compromise with the outgoing administration on important decisions.

Even if the worst of the financial crisis has passed (a dangerous assumption), the worst for the economy is almost certainly ahead. After their near-death experience, bankers have turned exceedingly cautious. A Fed survey released this week shows them tightening lending standards to consumers by a greater margin than at any time in the survey’s 40-year history, except for Mr Carter’s short-lived imposition of credit controls. General Motors says that last month’s car sales, relative to the population, have been the lowest since 1945.

How long, and deep, a recession?

The depth of the recession largely hinges on how long it takes for banks and private lenders to recover their appetite for risk. This, in turn depends on the course of home prices, loan losses and the ability of financial firms to raise capital. Some officials at the Fed think that the recession could be as mild as it was in 1990-91. If so, it would probably be over around mid-2009 and unemployment will peak somewhere near 7%. In a more pessimistic scenario, the recession would rival that of 1981-82, lasting into late 2009 with unemployment reaching 8-9%.

The Fed has brought previous recessions to an end by pushing interest rates low enough for long enough. Its job this time is harder. Though its interest-rate target has dropped to 1%, the benefits have been blunted by bankers’ and investors’ lack of capital and by their suspicion of customers’ creditworthiness. This has kept rates to corporate and household borrowers high. Corporate-bond yields are much higher now than 15 months ago when the Fed’s target stood at 5.25%.

Historically, presidents have had little influence over short-term economic growth, and certainly less than the Fed’s chairmen. But with monetary policy muffled, Mr Obama will bear more of the responsibility for fighting recession by way of fiscal policy. Congressional Democrats are already pressing for up to $150 billion in stimulus measures, such as aid to states and infrastructure spending. Mr Obama incorporated those goals in a two-year $175 billion proposal and may join forces with Congress to pass such a package in a “lame duck” session before inauguration day. Some advisers and outsiders want him to do even more. Economists at Goldman Sachs think that up to $500 billion in stimulus (3.5% of GDP) is necessary to offset the drop in private spending induced by tighter credit.

With stimulus of this magnitude, the costs of the bail-out and the recession’s withering effect on tax revenue, the budget outlook is dreadful; next year’s deficit could top $1 trillion. Given the alternative—an even worse recession—even deficit hawks will hush their protests.

But the president-elect has precious little breathing room. He faces momentous and unpleasant choices. One deadline is the expiration of Mr Bush’s tax cuts at the end of 2010. Mr Obama had originally promised to extend them for all but the wealthiest 5% of households, whose higher taxes (along with a withdrawal of troops from Iraq) would finance tax credits and health-care subsidies to working-class families. The Tax Policy Centre, a research group, puts the cost of his health-care plan alone at $1.6 trillion over ten years. His more liberal supporters will expect him to keep those promises. But with a deficit threatening to exceed the post-war record of 6% of GDP (set in 1983), such largesse risks revolt by the financial markets, a point that Mr Obama’s more conservative advisers will doubtless make.

In 1993 Mr Clinton, facing similar tension, ultimately sided with the deficit hardliners. If anything, the pressures on Mr Obama are even more acute. With baby- boomers about to retire in growing numbers, the cost of America’s public-health and retirement programmes, if left unchanged, will rise from 8% of GDP now to 19% by 2050. Some economists dream that the time is ripe for a grand bargain that reforms the tax code, entitlements, and health care simultaneously, boosting productivity, raising revenue, expanding health-care coverage and putting the budget on the path to long-term balance.

Towards sterner regulation

Mr Obama also faces big decisions on reconfiguring America’s system of financial regulation. The ad hoc takeovers, bail-outs and guarantees of recent months have vastly expanded the federal safety-net and increased potential taxpayer liability by trillions of dollars. The Fed and Treasury plan to wind down most of these programmes over the next two years, but it is tough to wean investors and banks from federal guarantees once granted. With six firms controlling three-quarters of America’s $14 trillion in banking assets, “We have developeda very serious too-big-to-fail problem,” Ben Bernanke, the Fed’s chairman, acknowledged last month.

Since none of these firms, or any financial company of systemic importance, can be allowed to fail, more intrusive supervision that limits risk-taking and thus profitability is inevitable. To replace the system of ad hoc rescues, Mr Obama’s advisers may press for rapid action on a formal “resolution regime” enabling the federal government to take over and wind down firms. The bail-out law requires him to decide by May how to regulate derivatives and hedge funds. Eventually, he must also decide whether to merge or reassign the responsibilities of America’s multiple federal and state regulators. The Fed has taken on extensive new powers in the past year—which may not be healthy either for the financial system or for the Fed, whose principal duties are to maintain stable prices and jobs. Mr Obama’s views on such questions will influence who he appoints to fill the three vacancies on the Fed’s seven-member board, and whether to reappoint Mr Bernanke whose term expires in 2010.

Economic problems abroad will also jostle for Mr Obama’s attention. The financial crisis has destabilised many emerging economies whose companies had participated in the credit boom. The International Monetary Fund’s $253 billion in resources could soon be critically stretched if other countries join Iceland, Hungary and Ukraine in seeking financial support.

The challenges facing Mr Obama are momentous; so is his potential. His solid mandate and strengthened majorities in Congress equip him with huge political capital. There is no shortage of problems demanding that he spends this capital.